Here’s what’s killing China’s economic growth

Opinion: Reform state-owned enterprises and investment will follow

By

SatyajitDas

Bloomberg

SYDNEY (MarketWatch) — Central to China’s economic growth is a shift from debt-driven investment to consumption.

China’s development has been driven by investment, which represents around 50% of Gross Domestic Product. About half of this investment is in property. Infrastructure investment is also high, far greater annually than the U.S. and Europe, but also than other emerging markets — double that of India and around four times that of Latin America. China’s total investment levels are also 10%-15% of GDP higher than comparable countries, such as Japan and South Korea, at the equivalent stage of development.

China’s central government wants to enhance domestic demand and consumption, but the task is made even more difficult by the influence that state-owned enterprises command over the national economy.

China has about 150,000 SOEs, which control around 50% of industrial assets and employ around 20% of the nation’s workforce. These SOEs receive plenty of government support — except they aren’t as profitable as their private sector peers. SOEs have become a drag on China’s economic potential and are need reform. How, and how much, that will happen is questionable.

That said, China’s consumption has not been static, growing strongly at around 8% annually over the past decade. However, the growth in consumer spending has been slower than that of the overall economy and the increase in gross fixed investment, at an average annual growth of over 13% annually, has dropped private consumption to about 35% of GDP.

If China’s economy grows at 8% annually , consumption needs to grow by around 11% just to increase the share of consumption one percentage point, 36% of GDP, in a year. Assuming a growth rate of 8% and consumption increases of 11%, it would take around five years to increase consumption to 40% of GDP. If growth slows, then the difficulty increases.

Second, legacy issues of rapid expansion and excessive investment will need to be managed. Many projects have dubious economics. The charges that would have to be levied to recover the capital cost and operating expenses of high-speed trains and toll roads, for example, are beyond the means of their users. Many investments will not generate sufficient revenues to repay the borrowings used to finance them, resulting in potential losses to lenders.

Third, boosting consumption will reduce savings, affecting the deposit base and cost of funding of Chinese banks, which will reduce their flexibility in managing rising losses from bad loans. It will also require a significant boost in household income, which will affect the profitability of Chinese companies that already operate on thin margins and are struggling to remain cost-competitive globally. It will necessitate investment in social welfare infrastructure, which will make claims on public finances.

Fourth, the rebalance will result in slower growth, at least during the period of transition, reflecting the reduction in the growth rate of or decline in investment levels. The resulting economic slowdown will further compound the challenges.

These difficulties mean that the temptation for China’s leaders is to continue a strategy of debt-fueled investment — at least until it is absolutely impossible.

State-owned surprises

China’s SOEs contribute around one-third of total economic value added. Yet probably only around 50 of the 1,500 listed companies on the two Chinese stock exchanges are genuinely private businesses.

The SOEs enjoy several advantages.

First, key sectors of the economy, such as construction, infrastructure, finance and banking, insurance, resources, media and telecommunications, are reserved for SOEs. A system of licenses and permits controlled by various levels of governments and the Chinese Communist Party guarantees government-controlled firms a major role in economic activity.

Second, SOEs enjoy preferential access to finance from state controlled financial institutions, receiving around 60% of all bank loans and more than 75% of the country’s capital. The SOEs benefit from low cost of this capital, reflecting their often monopolistic or protected market positions.

Third, SOEs benefit from a range of subsidies, ranging from tax benefits, subsidized input costs and preferred procurement position for government contracts.

Despite these significant competitive advantages, the profitability of SOEs lags well behind that of China’s four million to five million private sector firms, which are far more important in terms of employment, tax receipts and output. These private sector firms are responsible for about 80% of China’s urban employment and 90% of net new job creation as well as two-thirds of total fixed-asset investment.

SOEs sap the economy

The major role played by frequently large, unproductive and unaccountable SOEs distorts capital allocation and economic and financial inefficiencies. Protected SOEs frequently do not pursue profits or greater efficiency, choosing instead (with tacit government support) to increase size, diversify, make foreign acquisitions and acquire new technology.

This has contributed to overcapacity in many industries. One notable case was over investment in solar energy, pursuant to a government diktat to increase exposure to renewable clean energy. It resulted in a global glut of solar panels and the bankruptcy of Chinese manufacturers such as Suntech.

Local private sector and foreign businesses find it difficult to compete with large dominant SOEs, resulting in higher prices and limited product choice, which must borne by Chinese citizens.

The dominant role of SOEs, which favor heavy industry, may impede the development of China’s service sector. The Chinese government, in a moment of uncharacteristic candor, admitted to failing to meet targets in relation to service industries, which account for 40%-45% of its GDP and 35% of its employment, well-below the 60% or more in countries at a comparable stage of development.

Successive governments have recognized the need to reform SOEs. Following the 1993 plenum, then premier Zhu Rongji led a program whereby the number of SOEs was reduced by around half, with thousands of loss making concerns being restructured, sold or privatized with around 40 million workers losing their jobs.

Subsequently, reform of the SOEs slowed. This reflected concern about the loss of jobs and the fact that the remaining businesses were not loss-making, reducing the immediate need for restructuring. Over time, the state has reasserted its control over the economy with SOEs dominating critical sectors, including banking, finance, transport, energy, natural resources and heavy industry.

Large scale privatizations are unlikely. New reform initiatives focus increasing dividend payouts to boost government revenues and on the State acting as a patient, long-term investor maximizing the value of its holdings.

Not surprisingly, the SOEs oppose change. The economic and political power of large SOEs and their leaders, many of whom hold ministerial rank, may thwart reform. For example, removal of subsidies by the central government frequently results in provincial governments increasing these to maintain the business. For example, bankrupt Suntech was bailed out by Wuxi’s city government.

Confucius is reported as having stated: “Only the wisest and stupidest of men never change”. For the moment, Chinese believe it is wise to maintain the present strategy. History will judge their wisdom.

Satyajit Das is a former banker and author of “Extreme Money” and “Traders, Guns & Money.”

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